What is a Bear Market? A Complete Guide

Sometimes, during market cycles, the stock markets may plunge, and prices could fall. It may be for a short period of weeks or months, or even drag on for years. Is that a bear market?

Depending on specific circumstances, it may well be. But what are bear markets exactly?

Read on to learn more about bear markets, their outlook, and their phases. We’ll also explore some recent bear markets and their impact and discuss what one can do during market downturns.  

What is a bear market?

A bear market is when the markets experience a prolonged or continuous downward price trend. During a bear market, the prices of stocks, exchange traded funds (ETFs) and index funds may drop by over 20% from recent highs due to negative investor sentiment towards the market ^[1]. 

One way to predict a potential decline in the overall market would be to observe an index like the S&P 500 that tracks the 500 largest companies listed on US stock exchanges and look out for a prolonged decline in prices. When other securities like stocks, ETFs and commodities experience a drop of about 20% from recent peaks for over a couple of months, it could be a sign of a bear market as well. 

Bear markets may be a reflection of market recessions and other dire economic downturns.

Types of Bear Markets 

There are typically two types of bear markets: cyclical and secular bear markets ^[2].

Cyclical bear markets occur due to normal business fluctuations in an economy. These periodic bear markets appear almost every 6 to 10 years as a readjustment to prolonged periods of booming markets as all major sectors of the economy experience massive growth.

On the other hand, secular bear markets result from financial policy, slowed economic growth, bursting market bubbles, wars and pandemics. Secular market trends can often hurt investor sentiment, preventing them from investing in large quantities.

High interest coupons for bonds and treasury bills often cause secular bear markets as investors are incentivised to take advantage of these zero-risk instruments. As their demand for assets in the stock markets reduces, it can cause a bear market.

Let’s explore some common features of bear markets.

Characteristics of a bear market

So, what should you look for, to tell that you’re in a bear market?

1. Duration of the downturn

Unlike most drops in the stock markets, a bear market is usually extended. 

2. Underperforming stock markets

A general rule of thumb for a bear market is if the stock markets experience a consistent downward trend of more than 20% across all sectors ^[3]. 

3. Increase risk aversion

When the stock markets begin to trend downward, most investors put their money in safe haven investments and become risk averse. Some investors may sell their assets, wait for another perfect entry point when the storm calms, or settle for less volatile financial instruments. 

4. Economic Recession

Recession is a vital characteristic of a bear market. It may lead to an increase in unemployment, reduced spending habits, and inflation.

Causes of a Bear market

Let’s explore some reasons for bear markets.

Sluggish economic growth

If economic growth in your country slows down, it may lead to bear markets. Most people will reduce their spending habits because they can’t afford some products and services.

Businesses may also downsize, or close shop and producers may hoard products as they anticipate better prices in the future.  

Bursting market bubbles

Whenever specific business sector bubbles burst, it may cause the entire market to drop. The 2008 housing bubble and the dot-com bubble are great examples.

Investors may pull out from these investments and offset any more risk by getting out of those market sectors. Burst bubbles can erase the value of companies and destroy the capital of individuals invested in them.

Recession

A recession is another common cause of a bear market. Underemployment, unemployment, and a dip in business returns can pressure the stock markets and drive them down as fewer people take risks and invest in them. 

Public Health Crises

Global pandemics and other public health crises can drive the markets down the drain. In the example of the COVID-19 pandemic, investors pulled their money from most sectors of major economies as infections surged. That, coupled with mass lockdowns, led to a near-total economic shutdown. 

Many businesses closed, and the many prominent index funds saw an unparalleled decline.

Political conflicts

Conflicts can cause bear markets. Instability in a region can cause businesses and markets to shut down. A good example is the 2022 Russia-Ukraine conflict ^[4]. 

Also, pre-election periods or unfavourable electoral outcome can lead to bear markets, especially as investors hold back for fear of losing their capital because of fear, doubt and uncertainty. 

Interest rate trends

A continuous upward trend of interest rates by central banks can trigger bear markets. As bonds and treasury bills approach the returns the stock markets offer, many investors opt for these instruments to grow their money instead. This in turn could reduce the capital that is allocated towards the stock market. Also, investors optimise their portfolios and reduce their risk appetite as loan repayments become more expensive. 

Phases of a bear market

Before a full market downturn, some events will occur. Here are the phases the market undergoes before a full bear market hits ^[5].

Phase 1: Realization

At the early stages of a bear market, investor sentiments towards the markets change, moving from risk seeking to risk aversion.

Some investors will downsize their portfolio positions, while others will liquidate positions entirely. Others withdraw any upside, realising gains, and reducing their stake in various companies.  

Phase 2: Capitulation

At the capitulation stage, investors experience a sudden slump in the value of stock prices. Many outstanding companies and banks may also start reporting losses or diminishing returns. 

This phase often intimidates investors with exposed positions and alters their view of the stock markets. After that, they may withdraw from any market involvement. High-volume trading stocks start to drop, indicating a slumping economy ahead. 

Phase 3: Speculation

At this stage, investors begin to accept and understand the reasons for the downward market shift. Many investors begin to enter the markets and regain the confidence to take new positions, despite the market’s volatility. That may raise some stock prices and trading volumes.

Phase 4: Anticipation

In this last phase, many stock prices achieve support in their already low prices. Here, stock prices may rise again, and economies may improve as investors anticipate bull markets ahead. 

Past Bear Markets

Bear markets are fairly common. Most investors have experienced at least one cyclic bear market in their careers. However, some secular bear markets have made history in the past century ^[6].

Let’s look at some significant ones.

The 2020 bear market

In 2020, a bear market resulted from the COVID-19 global pandemic. This bearish trend started in March 2020 and was one of the shortest recorded ^[7].  

The S&P 500 Index Fund infamously fell by over 30% but slowly regained ground over subsequent quarters. Because of the rapid spread of the virus and widespread lockdowns, there was a global slump in economic performance. In the United States, unemployment peaked at 14%, and many small businesses closed down permanently worldwide.

The great depression

The great depression of 1929 is one of the world’s most famous bear markets. It was also known as the catastrophic economic shock, as it took out millions of investors. Wall Street went into a full panic, and many stocks fell below 80% ^[8].

For the next three years, the industrial sector in the US was underwater, and the unemployment level hit an ominous 24%. That led to a horrible drop in consumer spending habits. Over 4800 banks closed, and millions of civilians lost their savings. 

The dot-com meltdown

In the late 1990s, the world experienced a shift towards adopting the internet. This new trend drew in millions of investors who sunk massive amounts of capital into tech-related companies and businesses ^[9]. 

Unfortunately, many investors were not seasoned enough to test the valuation of such companies. As per the NASDAQ, the dot-com bubble was above 5000 points before bursting just before the year’s close. 

After that, early in 2000, investors lost massive amounts of capital because of poor asset valuation, as most upcoming internet businesses were scams. Plenty of internet company projects were unrealistic and unsustainable, leading to their closure and huge financial losses.

The housing bubble

The housing bubble resulted from high housing demand, which led to the rise in housing prices. The high demand for housing forced most investors to pump extra capital into the real estate sector ^[10]. 

The 2007 housing bubble in the US was primarily due to an increase in high-risk clients’ mortgage subscriptions with loose lending standards and weak regulatory oversight. In years leading to crisis, interest rates continued to hike gradually as homeownership reached a saturation point. Many people with no stable or sufficient income began to find it difficult to afford the loan repayment and default on their mortgages. 

The growing mortgage defaults subsequently led to the fall of mortgage-backed securities and other derivatives which track subprime mortgages as underlying commodities. The loss of value in these mortgage-backed financial products caused a panic that froze the global lending system and eventually burst the housing bubble, wiping out trillions of dollars’ worth of investment in subprime mortgages.

Over 9 million jobs were lost and an estimated 10 million lost their homes ^[11].

Practices for investors during bear markets

Whenever a bear market comes around, here are some actions you may consider ^[12].

Diversify your holdings

Diversification is one key strategy to help you better prepare for, and handle bear markets. Instead of investing in a single asset class like real estate, distribute your risk and capital across the market and purchase commodities, bonds, index funds, shares and more. 

A gain in one asset class can potentially offset other losses incurred due to a bear market. For instance, a gold position may potentially offset stock losses incurred during a bear market. Also, investing in ETFs and index funds is another option because a single losing company in the basket doesn’t necessarily bring the entire index down.  

Adjust your asset allocation

As your investment goals change, align your current asset allocation strategy with your financial goals. In a bear market, that may mean considering re-allocating capital to assets with less risk.

Only invest in assets that fit your investment strategy. If you have a risk appetite, ensure you understand and can afford any potential downsides to your decisions. If you are risk averse, focus on low-risk assets with stable returns. 

Don’t sell emotionally

During a bear market, avoid panic selling your assets. If you have long-term investments with a potential for future gains, you may consider holding on to them instead. Certain assets with healthy financial standing and profitable business model may recover in the next bull run as the markets recover.

Use dollar-cost averaging

Instead of waiting for the markets to recover before getting into advantageous positions, you may use the dollar-cost averaging method to enter the market. 

Dollar-cost averaging involves investing fixed amounts of cash at regular intervals. It may lower your investment costs in the long run and help you diversify your portfolio.

References